What's Next For Aerospace And Defense?

Aerospace and defense led markets sharply higher following Trump's election and the idea of fiscal stimulus - lower taxes, higher defense spending - it ostensibly promised. However, as political headwinds continued to mount this year, markets began to price out fiscal stimulus, and "Trump Trade" began to unwind, leaving many advisors to ask, "What now?" Investors may want to consider the following:

Longer cycles, more growth potential

New buyers

Shifting line items in the DoD budget

Valuations may have room to run

Aerospace and defense relative performance

Aerospace and defense relative performance

Source: Thomson Reuters, as of October 26th, 2017. The indexes shown are the Dow Jones U.S. Select Aerospace & Defense Index relative to the S&P 500. Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Aerospace

Airline service has deservedly gotten a bad rap, but we believe the aerospace industry has a lot going for it. The sector can be divided into two segments, original equipment manufacturers (OEMs) and industry suppliers. Overall, the sector has grown faster than nominal GDP, has maintained consistent pricing, and has kept new entrants at bay with highly technical intellectual property.

Longer cycles, more growth potential: OEMs have benefitted from a long, secular growth trend since the 1980s. While OEM growth cycles have historically been short and sharp in magnitude, they have lengthened over time. Indeed, since 9/11, the industry has been in a 'super cycle,' as aircraft shortages, emphasis on fuel efficiency, and the rise of new emerging and low-cost air carriers have driven orders. Large backlogs at OEMs have continued to grow (albeit at a slower pace). Meanwhile, suppliers' returns have consistently outpaced even OEMs due to higher aftermarket content for used parts, lower upfront investment, and lower program risks. Although aftermarket growth has slowed to high single digits, it has continued to track nominal GDP. What's more, global traffic, measured as revenue passenger mile (RPM), has grown about twice as fast as nominal GDP over the past 40 years.1

New buyers: The mix of air traffic has shifted dramatically in recent years towards regional carriers in the developing world, particularly Asia and the Middle East, where they serve a rising middle class. In 2000, the U.S. and Europe accounted for 65% of the 2 trillion in global RPM. By 2025, the U.S. and Europe are estimated to account for just 44% of the 5.1 trillion in global RPM.2

Defense

Aerospace isn't the only U.S. industry that has seen international demand driving growth. U.S. military spending is roughly a third of the $1.7 trillion global defense market.3 However, the question going forward is what will the U.S. military look like under the Trump administration.

Shifting line items in DoD budget: Early signals suggest that increasing the defense budget will remain a priority for the current administration. Heavyweights in the industry are quite dependent on the U.S. government for their revenues, but there has been a recent shift in focus. Following the 2013 budget sequestration, the Department of Defense (DoD) has prioritized capability over capacity. We believe the emphasis on capability may bode well for industry revenue, as manufacturers have been forced to deliver efficiency gains, and defend or increase margins in the leaner years. The government is having another, less direct impact on defense spending, namely an increase in demand for weaponry and tech as geopolitical tensions rise.

Valuations may have room to run: Defense spending growth is likely to continue under the Trump administration, in our view. Thus, the rise in price-to-earnings multiples for the group may be justified, as spending is sticky and somewhat predictable in the short run. Other factors are harder to predict, however. From a balance sheet perspective, any relief from potential tax reform and flexibility on capital spending deductions may be a boost, while higher interest rates may help ease pension liabilities; that said, we believe even stable or lower rates should make their historically stable dividends increasingly attractive.

Role in a portfolio

The Aerospace and Defense sector comprises a broad mix of companies with unique super-trends that historically helped their performance. This can help add diversification benefits as part of the industrials sector within a cyclical basket. U.S. government policy has a big impact on the sector, and the current administration makes a good upside case, in our view. Any downside will be determined by spending patterns and emerging market demand, although both have been stable and are structurally improving at the moment. Regardless of the outcomes of such large unknowns, macro patterns like the growing emerging market middle class, shifts in global defense budgets and the impact of technology and efficiency, have made Aerospace and Defense stocks a sector to consider in a long-term portfolio.